Quicky #3 on L’Occitane

This is part # about one of my smaller ‘legacy positions’ which I bought into without a deeper analysis. As many retailers the company was and is strongly impacted by the pandemic. Time for a quicky (which got a bit longer) …

This is not investment advice. Please read the disclaimer.
I currently own shares (economic interest) in mentioned companies.

L’Occitane International S.A. (L’Occitane, the group or the company) descibes itselfs as ‘a natural and organic ingredient-based cosmetics and well-being products retailer‘. The stock is listed in Hong Kong (973 HK), but the company is incorporated under the laws of Luxembourg (a tiny country in Europe). Not surprisingly, the stock got hammered as a special retailer, falling almost 50% during the first three months of 2020. The stock price rebounded 30% from the March lows. My aim in this post is to establish a rough estimation for the stocks fair value …

This is another part of my series of Quickies on new companies.

General reporting

L’Occitane’s financial year ends at March 31st. Accordingly, the final quarter of the most recent financial year (FY 2020 Q4) ending March 31, 2020 was impacted by the global pandemic as was Q1 of the new financial year (FY 2021). The company merely provides quarterly sales updates without any other financial results. I believe, this fact, inflicts higher (perceived) uncertainty and less material for sell side equity analysts to update their reports frequently potentially resulting in lower investors’ interest. This may very well provide the stage for attractive returns.

L’Occitane generates impressive gross margins above 80% for the last two years. But after high distribution expenses of more than 45% of net sales, marketing expenses (+12%), and general and admin exp. (10%) the company only generates an operating margin of ~ 10% on the company level. Can the company (i) return to stronger overall growth post covid and (ii) earn higher margins throughout its product and brand portfolio? Let’ take a closer look at L’Occitanes operations …

This is another special retailer in some kind of turnaround situation. Pandora was a company in a similar situation that I analyzed. I need to suppress any potential biases arising from this profitable Pandora investment.

Sales breakdown

extraction from FY2020 presentation (p 5)

Sales to end-customers accounts for about 70% of net sales (labeled sell-out). The remaining 31% are made up of sales to retailers (labeled sell-in). The former enables direct customer relationships and more ‘control’ of the brand appearance but does usually come along with a higher (and more unflexible) cost structure as rent, personnell, and marketing has to be payed. The latter can invoke inventory problems (channel stuffing) and represent the brand in an underised way. Sell-out can be prone to time lags when (negative) sales dynamics occur (learning from Pandora).

A strong presence in Asia results in dependency on local key markets. Four Asian markets account for 36% of total sales and are home to 456 of a total of 1,608 group-operated stores (AR 2020 p4, p17). Asia Pacific accounts for 25 out of 36 net openings (p14), illustrating the importance of the region within the company’s ‘selective retail expansion strategy’ of group-operated stores.

Japan (14% of sales, #163 own stores) is known for its special culture,its people are known to go in for quality and esthetics. I have the impression that L’Occitane caters to Japanese people’s need for esthetics quite well (take a look at AR 2020 p 8-9 for an impression). Thus, the company should have the opportunity for generating good profits in the market. However, the Japanese sales were -1.7% in local currency (reported 4.4%) due to soft retail market. Same store sales came in at -4.5%. A sales tax hike in FY 2020 Q3 and covid had negative effects. But performance was less than stellar before. In H1 2020, Japan showed reported growth of +4% yoy, but negative same store sales of -0.3%. With negative same store sales, opening new stores (+9 yoy) is questionable.

China (12%, #203) could become a hughe market for L’Occitane (as for almost any other company …). Chinese consumers had more than their fair share of product scandals, resulting in high faith in foreign brands. Additionally, western brands can be a possibility to show (higher) status. Same store sales growth came in at -3.3% for FY 2020 (not bad remembering the pandemic hit the market first). China’s potential becomes clear looking at its stellar sales performance during the first nine months of FY 2020 (9M 2020):
(supporting effect being Chinese shopping locally instead of HK, see HK issues below)

  • same store sales +8.4% yoy, up +1.6bp from 9M 2019 (+6.8%)
  • reported sales +22% yoy
  • net opening of +13 stores, group operated (seem to be the right move)

Hong Kong (7.6%, #35) is a very special market for luxury retailers. During usual times, many people (locals, tourists, etc) are willing to spend their money and show what they earned. In FY 2020, social unreasts, restrictive measures due to covid and travel halts hampered retail consumption. On a net basis, one shop was closed.

Read more about Hong Kong and why it is a special market
in my post about another luxury retailer.

Taiwan (2.5%, #55) showed outstanding resilience as one of two major markets (besides Russia) with positive same store sales (up 2.9%) during the last financial year. This fact is most probably based on the country’s appraised handling of the pandemic crisis. During FY 2020, the company increased group-operated stores +2.

Other important key markets include the US, UK and France. Elemis resulted in superficially high reported sales growth in the US and UK region. Reported same store sales were negative for all three regions in FY 2020, and were less than stellar in the first nine months as well. On a net basis, in the US -12 Group-operated stores were closed (UK -2, F +1).

Brands

Brands perform very differently. L’Occitane en Provence basically provides all of the company’s operating profits of € 187m as the highest grossing brand. The brand generated profits of 181m for a margin of 14%. Elemis was a key growth and profitability driver and earned 29m with a top margin of 17% (23% if you adjust for acquisition costs and some related amortization). LimeLife and other brands contributed negative margins.

extraction from FY2020 presentation (p 12)

L’Occitane en Provence accounts for 3/4 of sales. The core brand participates in higher awareness (and demand) for the importance of hygiene and self-care due to corona. The brand is sold offline and online. The company aims to lower dependence and diversify towards other brands.

Elemis is the profitable growth engine which (in the future) could justify the acquisition in 2019 for ~$900m at rather high multiples of 6.4x sales and 22.6x Ebitda. Elemis accounted for 10% of net sales in FY 2020, earning an elevated margin, due to its ‘lean and efficient structure’. The maritim channel was severly impacted by covid, but offline channels were driving sales growth. Within its digital-first strategy, Elemis opened its online store on TMall Global and a domestic launch in China, plus several other
markets in Asia, is planned.

LimeLife is build around a social media-based business model. After a rebranding, LimeLife could potentially turnout to be an exestantial driver to acquire younger customers.

Other brands summerizes the group’s emerging brands (Melvita, L’Occitane au Brésil and Erborian). Toghether these three brands merely account for 6% of total sales and contributed an operating loss for FY 2020. Erborian had a more positive development.

Vast store network

L’Occitane has a vast global network of stores. As per March 2020, there were a total of 3,486 retail locations of which the group operates 1,608 stores (+36 yoy). Such a retail store network is usually accompanied by high leasing liabilities (422m, see below) which result in periodic down-payments including interest (or rental expenses).

Same store sales growth is the all-important metric. This metric describes the yoy sales growth per store, for stores that exist for at least 24 months, ‘including company owned e-commerce websites’ (AR 2020, p12). Since a high portion of a retail store’s operational cost base is rather fixed (instead of variable) there is usually strong operational leverage at work. Thus, increasing sales per store usually result in much higher profitability (and vice versa).

Managing the footprint can generate shareholder value. Profitability needs to be evaluated on a store-level and growth initiatives (net openings) should be directed towards the most promising markets. The net store openings point in the right direction, it seems.

The pandemic

The global pandemic lead to a high number of store closures and resulted in much lower retail sales, serving a severe hit to L’Occitane’s top line. Stores’ reopenings happend fastest in the important Asia region. Most stores can be expected to be reopened at the end of September. But still, risk of local infection spikes and a general second (or third) covid wave remains. This presents a key risk for the important christmas season, usually generating much higher sales. Foot traffic could be depressed and all travel-related business could need years to recover to pre-covid levels (esp. airport shops, maritime business, tourist shoppers). But the company strengthened its liquidity and the balance sheet (see appendix) strength should be sufficient.

extraction from FY 2021 Q1 update

There were some positive effects as well. Due to the pandemic, people are more aware of the importance of hygiene and skin care. The online business was (forcedly) pushed forward. And many people spend most of their time at home currently, due to social distancing measures. For many people not experiencing a cash crunsh, it would be an obvious decision to spend most of their spare cash on home improvement and some luxury or well-being items for use-at-home.

Bed Bath & Beyond (BBBY US) experiences a special business cycle with a strong recovery in its share price and will be featured in a quicky after its investor day.

Valuation perspectives

L’Occitane trades at a P/E of 18x based on its current market capitalization of € 2.2 bn (as of Oct 7th) and annual net income of approx. € 120m for the last few years. That is certainly not a steal, especially considering that net income could well be lower for the foreseeable future. But much higher earnings could be in the making if the company gets a few things right:

Reviving growth in key regions and across the brand portfolio could boost L’Occitane’s top line (and profitability). Admittedly, some factors are out of the comany’s control, such as social unrests in HK, but overall, same store sales have to be revived through smart management decisions.

Driving profitability across the store network and across its brands portfolio is key for high shareholder returns. Closing under-performing stores and growing the store network in profitable markets is an important piece of the profitability puzzle. Managing the store network is a task the experienced management is up to, I believe.

L’Occitane has a portfolio of diverse brands as described above (see brands). These brands perform quite differently with regard to operational metrics, as presented in Note 5 – Segment information of the AR 2020. Only adding up the positive segment contributions would result in Ebit of € 210m (+12%) instead of 187m (reported). This view could make sense if you believe that the negative contributions, caused by ‘growth initiatives’ or brands in development will turn into positive contributions in hte future.

Attention: Since FY 2020 considerable interest (8.7m) and leasing exp. (14m) are allocated below operating profit (Ebit), see cons. I/S (p85) and note 25 (p174).

extraction from AR 2020, p135

Conclusion

For now I believe it is worth it to wait and see how this story turns out. I will hold on to my small position in L’Occitane which I bought in June 2018. Besides sales updates on a quarterly basis more detailed financial results are only released annually, so we have much time to wait and see …

I hope you enjoyed this (longer than usual) quicky about L’Occitane. What’s your opinion?


Appendix

Ownership structure

As of March 2020, LOG or L’Occitane Groupe S.A. held 73% of the company’s share capital. Another 7% were held by ACATIS, a German investment company, which I personally hold in high esteem. Furthermore, the company held 15.2m treasury shares.

Management

Reinold Geiger is calling the shots at L’Occitane since 2000, and is nowadays CEO of the company and the controlling shareholder AR 2020 (p 55, 67). He holds key positions at many related entities as well. Via LOG, he has interest in the company ‘P2S2’ which does business with L’Occitane (p74). This relationship could result in a conflict of interest, but in general the incentives seem to be (strongly) aligned with common shareholders based on his high ownership.

OK-ish balance sheet

L’Occitane strengthened its balance sheet with regard to the pandemic and related high uncertainty of future developments. Observations related to most recent consolidated balance sheet numbers, as of March 31 (AR 2020):

Goodwill and intangibles equal equity. The total balance sheet of € 2.4 bn is roughly funded by one half total equity and the same amount of total liabilities. The company has more than € 1.1 bn of goodwill and intangibles on its balance sheet, basically matching its total equity.

Net debt stands at € 730m. The company had borrowings of € 475m and leasing liabilites of € 422m. Most of the borrowings have their origins in the takeover of Elemis in 2019. The company had € 166m cash at hand and undrawn credit facilities of € 230m.

L’Occitane pays moderate interest on its debt. Interest expenses of € 8.8m were due on the borrowing (1.85% of 475) and a further 14m were due to leasing liabilites (3.3% of 422m). According to Note 25 in its AR 2020 (p 174), the company earned interest of € 2.6m on its cash and equivalents (which seems high compared to an average cash balance of € 155m).

I wrote a three articles about IFRS 16 and how to treat leasing liabilities when valuing a company, see here.

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